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Exploring the Effects of Investor Sentiment on the Stock Market

February 20, 2014

Researchers have debated the influence of investor sentiment (i.e., optimism versus pessimism) in financial markets. They have crunched the numbers to identify asset-pricing anomalies and corresponding trading strategies that might take advantage of the mispricing. Carlson School Associate Professor Jianfeng Yu has combined those two bodies of thought in his latest effort to unpack the role of investor sentiment on the performance of anomalies-based trading strategies.

"The claim is that if you execute these strategies over extended periods, they will be profitable on average," says Yu. "But most didn't say when these strategies would be more profitable."

Yu and colleagues studied 11 of the most prominent trading strategies to determine how well they performed during optimistic- and pessimistic-sentiment periods. Controlling for various economic forces with the help of decades of historical data, they discovered that most of these strategies failed to generate statistically significant profits when investor sentiment was pessimistic.

Rather, these strategies generated gains when investor sentiments were optimistic. Further, the gains came from "shorting," i.e., selling in anticipation of a price drop. Why?

"Overpricing occurs when we get over-exuberant," Yu says. "In turn, it creates opportunities for shorting, which can be highly profitable. In other words, if you're a portfolio manager and employ a trading strategy that tries to exploit market mispricing, it tends to work better in optimistic sentiment periods," says Yu.

Conversely, during historically pessimistic sentiment periods, Yu observes, "There are not as many underpriced securities because underpricing is more readily corrected by professional investors. So, anomalies (and corresponding trading gains) tend to be weaker during such periods."